Anything (with asset or commodity-like attributes) that can be independently measured by money (i.e., has a price) or an index could have a derivative. The focus of the derivative is changes in the price/index of the asset (or bundle of assets, as in a security) or the probability of a price or index movement (often referred to as an ‘event’). The form of the derivative will then specify how money changes hands as that measurement goes up or down. Commonly-traded derivatives address interest rates, exchange rates and oil price movements, but more recently-developed derivatives address such things as credit default risk, house price movements or temperature changes.

Securities, while not simply derivatives, have a critical derivative dimension. Securities are bonds issued on the basis of assets and expected income streams associated with those assets. Mortage backed securities are bonds in which the purchaser of the bond acquires an income stream linked to a bundle of mortages. The derivative dimension is that the buyer of the security has acquired an exposure to the performance of an asset (mortage repayments) but without owning the underlying asset (the mortages or houses themselves). The price of the security therefore varies with the rate of repayment of mortages, not with house prices per se.

An essential dimension of derivatives, therefore, is that they involve competitive positions on directions and degrees of change. As many facets of economic and social life change, and in ways that might be measured, the potential for innovation in derivative products is enormous. The potential depends essentially on whether there can be an independent (verifiable) measure of change (so that markets cannot be readily manipulated) and whether there would be enough demand for the product to make a derivative market profitable to operate.5

What is involved in the ownership of a derivative?

A derivative gives ownership of a financial exposure to the performance of the underlying asset: a right to buy or sell or to a payment when the price/index of the underlying asset changes. In this sense a derivative is a contingent claim, because its price will depend – is contingent – on future circumstances. But, and this is critical, it involves no (necessary) ownership of the underlying asset. With an oil future or option, one is not buying/selling a barrel of oil (the underlying asset), although that could be the ultimate intended consequence, but buying/selling exposure to changes in the price of a barrel of oil (contingency).6 With weather derivatives, to take another example, there can be no ambiguity about the underlying ‘asset’ being traded: markets trade an indexed measure of rainfall or temperature or frost, but one cannot buy and sell the weather itself. In this light also we can understand a mortage-backed security as having derivative-like elements. The owner of the security owns a monetary exposure to the performance of a bundle of mortages : that is, there is ownership of repayments on the mortages; not ownership of the mortages themselves.

Ownership of exposure to the performance of assets without ownership of the underlying asset has two practical advantages. First, it creates a leveraged exposure to the underlying asset: it is a cheap way of participating in the returns that come with ownership. Second, it makes transfer of this kind of ownership simple: it is much easier to trade ownership of an oil derivative contract than to transfer ownership of a barrel of oil. By making transfers of risk ownership simple, derivatives also make it possible to separate or combine different risks together into new ‘synthetic’ products. It is this ability to make assets fungible (to blend attributes of capital) that has helped make derivative markets so liquid. The focus of derivative ownership, therefore, is intense price competition on the performance of capital, but freed from the impediments of either physical or legal asset ownership.

Who trades derivatives?

Derivatives are generally associated with prices or indices whose movement is not readily predictable, but where those movements can have widespread or otherwise significant financial consequences. There are some who fear the price or index going down, and some who fear it going up. If their fears are significant, then investors may be willing to purchase a financial instrument to have the fears abated. And there will be still others, usually depicted as ‘speculators’, who want to take on bets about the price or index movement.

Derivatives are, therefore, integrally tied to risk – although strictly speaking to both risk and uncertainty. It is well understood that to make profits, there must be risks. But companies (and individuals) face all sorts of risks. Some they are happy to hold, for they are integral to entrepreneurial strategy (or, for individuals, integral to life experience). But other risks are not wanted. Indeed, all corporations (and individuals) would sell off (neutralize) some risks, and be prepared to pay to do so, at least up to a certain price. And someone must be on the other side of these contracts. They may be a party with a symmetrically opposite risk, or they could be investment bank, hedge funds or sovereign wealth funds, looking to earn a premium for taking on that exposure.

As such, most derivative products are associated with businesses where there are profits consequences of price/index movements. To look at who is trading these products, the Bank for International Settlements (BIS) Triennial survey of Foreign Exchange and Derivative Markets gives some broad insight. The BIS published survey, for 2007, shows that the share of trades undertaken by big banks7 had fallen from 60 percent in 1998 to 38 percent in 2007, while the share undertaken by ‘other financial institutions’ has grown from 20 percent to 3 percent of turnover.8 Central to the ‘other financial institutions’ category are pension funds and hedge funds (addressed shortly).

Securities, in particular, have emerged as a significant source of private debt growth. Between 1990 and 2008 asset-backed securities made up 43 percent of private debt in the advanced capitalist economies, with an annual growth rate of 19 percent. Corporate bonds, conversely, made up just 8 percent of the corporate debt, with an annual growth rate of just 6 percent.9 Hence those wanting debt-exposure to corporations are gravitating towards securities rather than corporate bonds, and corporations themselves are increasingly drawing on securities rather than financial institutional lending to raise debt. Beyond the corporate securities lie a raft of other asset-backed securities and collateralized debt obligations. These securities have been purchased by two primary categories of investors: investment banks, pension funds and hedge funds10 on the one hand and sovereign wealth funds of the surplus economies of Asia and the Middle East on the other.11

As we will consider shortly, these products are not entirely internal to the corporate and financial world. The process of securitization draws households into the mix, albeit as providers of income streams for securities rather than as market traders.

(to be continued in part 3)

* Capital-A Critique of Political Economy, Karl Marx, Volume 1, Preface the First German Edition (1867)